Kodak Doesn't Profit as Facebook Bets a Billion on Photo Sharing

The prices for Kodak Gallery and Instagram show that some will pay for growth over financial performance.

Antoine Gara

NEW YORK (TheStreet) -- Facebook could have bought a photo sharing site on the cheap.

Instead, the social network flexed its pre-IPO financial muscle in a
$1 billion acquisition of photo-sharing app Instagram.

The bargain photo sharing deal went to Shutterfly(:SFLY), which on Wednesday said a $23.8 million bid it made in March for Kodak Gallery, the pioneering photo sharing service from the bankrupt camera inventor Eastman Kodak, was the winning bid. There were no competing offers.

The divergence in the valuation of Kodak Gallery, an established and profitable business, and Instagram, a two-year old company with no revenue, shows that in some Silicon Valley circles, growth potential trumps the financial performance of an established business model.

While Kodak Gallery is a photo storage and album-creating site with 75 million users and an app that connects to email, text and even Facebook, it was Instagram's smaller, but fast-growing mobile app-oriented social network that Mark Zuckerberg targeted in a deal that was roughly 42 times more expensive.

Amid Facebook's rise and Kodak's collapse, the lack of interest in Kodak Gallery may also signal just how specific M&A needs are as social networking giants and Silicon Valley titans work to follow consumers into mobile products and round out user experiences.

For Shutterfly, Kodak Gallery may bolster its photo sharing capabilities in an opportunistic move that wards off prospective competitors such as Apple(:AAPL), and social networks threatening its profit margins.

In March, many analysts considered Shutterfly's bid for the customer accounts of Kodak Gallery to be a turning point for the company's profitability and pricing power, while thwarting the likes of Apple and Amazon(:AMZN) from entering the photo sharing market. Although the move pushed the company's shares up over 16% to $31.36 on March 2, Facebook's April 9 deal for Instagram led to a drop in Shutterfly's stock as some investors saw an increasing challenge to its business and Kodak Gallery bid.

Instead, the lack of competition during the Kodak Gallery's bankruptcy auction and a over 5% Tuesday rally in Shutterfly's shares to nearly $31 may speak volumes about what Silicon Valley leaders like Facebook are looking for in acquisitions. After announcing the $1 billion Instagram deal, reports indicated that Facebook CEO Mark Zuckerberg brokered the move in the matter of days after watching the network's quick adoption on Google's(:GOOG) Android mobile platform, adding to its 15 million iPhone users.

When making his biggest acquisition ever, Zuckerberg said that Instagram and Facebook combined will, "offer the best experiences for sharing beautiful mobile photos with people based on your interests." It's those needs, over bread and butter revenue and profit that may be the big surprise in the diverging prices of Kodak Gallery and Instagram.

Nevertheless, Shutterfly isn't likely to fret over the valuation analysis of Facebook.

"Our acquisition of Kodak Gallery is a perfect example of the consolidation that we believe will play an important role in helping Shutterfly solidify our leadership position in the social expression and personal publishing category," said Shutterfly CEO Jeffrey Housenbold in a statement.

The prominence of Facebook, a surge in low priced competitors, and the use of daily deals promotions led to margin erosion in 2011 for Shutterfly and its competitors. Pricing pressures are expected to persist in 2012.

"For Shutterfly to eliminate of one of the few scale players in the industry for the proposed price of only $24 million appears to underscore the company's dominance within the industry and the financial weakness of its competitors," wrote Mitch Bartlett of Craig Hallum Capital in a March 2 note.

Shutterfly won't take on the Kodak brand or any of its operating assets or liabilities in a deal that analysts expect to be a long-term jolt to the company's earnings that may be the catalyst to push shares in the direction of 2011 highs, after a second half stock swoon.

"We view this as a prudent use of capital to further consolidate share and potentially mitigate industry pricing pressure," wrote Janney Capital Markets analyst Shawn Milne in a March note reacting to Shutterfly's initial bid. Milne estimated that the Kodak Gallery generates roughly $75 million in revenue, which when added to Shutterfly's earnings, will boost earnings per share by up to 15 cents in 2012.

While the deal may help on pricing and show that other players are struggling to grow, it may also remove the threat of a new entrant like Amazon or Apple that could add an even greater hit to Shutterfly's future profits.

By making the move, Shutterfly removes "the threat of a new or larger competitior (e.g. AMZN, AAPL) entering the space through the Kodak Gallery assets," added Bartlett.

Shutterfly carries its photosharing capabilities on the Apple iPhone and iPad, in addition to other smart devices that run on Google(:GOOG) and Microsoft(:MSFT) software.

An earnings drain that Shutterfly saw from daily deals sites like Groupon(:GRPN) and Amazon's Livingsocial has also moderated. CEO Housenbold said in a recent Morgan Stanley conference that he has identified a new daily deals strategy, as seen in Shutterfly's fourth quarter earnings.

Shutterfly was able to turn a fourth quarter profit after a string of 2011 quarterly losses, bolstered by a more targeted and analytics-based use of deals sites like Groupon and Livingsocial. "What changed in the fourth quarter, was the growth and pervasiveness in the daily deal category," said Housenbold of Shutterfly's continued, but changing use of the sites.

In late 2011, as Kodak was hurtling toward bankruptcy, many saw a sale of its Kodak Gallery business as helping the company raise cash to avert a bankruptcy filing. In November, the Wall Street Journal reported that private equity firms and retailers were looking to buy Kodak Gallery. According to anonymous sources familiar with those talks, the sale was expected to net "hundreds of millions of dollars" for Kodak.

Since Kodak entered bankruptcy in January 2012, the company has been selling assets in bankruptcy court as it looks to re-emerge as a slimmed down business that no longer makes digital cameras.

On Monday, CNBC reported that Facebook may push its initial public offering to June because of its M&A activity. The worlds largest social network bought $550 million worth of AOL patents from Microsoft(:MSFT) and reported falling revenue growth and profitability in its third quarter earnings, earlier in the week.

For more on Shutterfly, see 5 stocks that could rise. For more on Kodak's last ditch efforts to sell patents and avert a bankruptcy, see more on why its patent pivot wasn't enough.

-- Written by Antoine Gara in New York

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